Monthly Archives: July 2015

Much of the discussion about cryptocurrencies has naturally centered around Bitcoin. Also, this discussion has been particularly focused on the role of Bitcoin as an alternative currency. However, I think that the most important aspect of Bitcoin (and cryptocurrencies more generally) is not necessarily the alternative currency arrangement, but the block chain. It seems to me that the future viability of cryptocurrencies themselves is not as an alternative to existing currencies, but as assets that are redeemable in a particular currency with payments settled much more efficiently using block chain technology.

For those who know little about cryptocurrencies, the block chain can be understood as follows. A block chain is a date store, or computer network in which information is stored on multiple nodes. In the case of cryptocurrency, such as Bitcoin, the block chain is used as a ledger of all transactions. Since every node has access to the block chain, there is no need for any centralized record-keeper or database. Transactions that are carried out using Bitcoin have to be verified by the nodes. A successful transaction is then added to the block chain. Individuals using the system must therefore have balances of the cryptocurrency recorded on the transaction ledger in order to transfer these balances to someone else. In addition, once the nodes verify the transferred balance, the transaction is time-stamped. This avoids scenarios in which people try to double spend a given balance.

This technology is what creates value for Bitcoin. One explanation for why money exists is that people cannot commit to future actions. The lack of commitment problem makes credit infeasible. Money is an alternative for carrying out exchange because money is a record-keeping device. The block chain associated with Bitcoin is quite literally a record-keeping device. It has value because provides a record of transactions. In addition, this simplifies the settlement process and therefore reduces the cost of transfers and settlement.

The benefit of using Bitcoin is thus the value of the record-keeping system, or the block chain. However, in order to be able to benefit from the use of the block chain, you need to have Bitcoins. This is problematic since there are a number of reasons that you might not want Bitcoins. For example, maybe you are perfectly happy with dollars or perhaps you’ve noticed that there are not a whole lot of places willing to accept Bitcoins just yet. Also, you might have noticed that the exchange rate between Bitcoins and dollars is quite volatile.

So if you are unwilling to trade your dollars for Bitcoins, then you don’t have access to the block chain and cannot take advantage of the more efficient settlement. This, it seems to me, is a critical flaw with Bitcoin.

Nonetheless, the technology embodied in Bitcoin is available to all and can therefore be adapted in other ways. Thus, the critical flaw in Bitcoin is not a critical flaw for cryptocurrencies more generally. The value of these cryptocurrencies is in the blockchain and the true value of the block chain is in figuring out how to use this technology to make transactions and banking better and more efficient. There are two particular alternatives that I think are on the right track, NuBits and Ripple.

Think back to pre-central banking days. Prior to central banks, there were individual banks that each issued their own notes. Each bank agreed to redeem its bank notes for a particular commodity, often gold or silver. Bank notes were priced in terms of the asset. In other words, one dollar would be defined as a particular quantity of gold or silver. This therefore implied that the price of the commodity was fixed in terms of the dollar. In order to maintain this exchange rate, the bank had to make sure not to issue too many bank notes. If the bank issued too many notes, they would see a wave of redemptions, which would reduce their reserves of the commodity. In order to prevent losses to reserves, the banks would therefore have an incentive to reduce the notes in circulation. The peg to the commodity therefore provided an anchor for the value of the bank notes and represented a natural mechanism to prevent over-issuance. Thus, fluctuations in the value of the bank notes tended to result from changes in the relative value of gold. (The U.S. experience was actually much different. Due to the existence of a unit banking system, notes often didn’t trade at par. Again, let’s ignore that for now.)

The way that NuBits work is a lot like these old banks worked (without the lending – we’ll have to get to that in a different post). The NuBits system consists of those who own NuShares and those who own NuBits. Those who own NuShares are like equity owners in the system whereas those who own NuBits are like holders of bank notes. The NuBits are redeemable in terms of U.S. dollars. In particular, one dollar is equal to one NuBit. If I own a NuBit, I can redeem that NuBit for one dollar. So how does NuBit manage to do this when Bitcoin clearly experiences a volatile exchange rate? They do so by putting the trust in the equity owners. Owners of NuShares have an incentive to maintain the stability of this exchange rate. If nobody is willing to use NuBits, then there is little value of ownership in the protocol and the shares will have little, if any, value. Thus, the NuBits system provides an incentive for NuShares holders to maintain the stability of the exchange rate and gives these shareholders the ability to do so. For example, if the demand for NuBits falls, this will be seen by a wave of redemptions. This is a signal that there are too many NuBits in circulation. In order to maintain the exchange rate, NuShares holders have an incentive to reduce the quantity of NuBits in circulation. They can do this by parking some of the NuBits (i.e. preventing people from using NuBits in transactions). This is not done forcibly, but rather by offering interest to those who are willing to forgo engaging in transactions. Similarly, if there is an increase in demand then new NuBits can be created.

But while NuBits has solved the volatility problem in a unique and interesting way, they still suffer from the same problem as Bitcoin. In order to be able to benefit from the technology, you need to hold NuBits and there is perhaps even less of an incentive to hold NuBits since it is much harder to use them for normal transactions. Thus, until cryptocurrencies like NuBits can be used in regular everyday transactions, there is little incentive to hold them. Thus, NuBits gets partially where the technology needs to go, but still suffers from a similar problem as Bitcoin.

This brings me to Ripple. Ripple is a much different system. With Ripple, one can set up an account using dollars, euros, Bitcoins, and even Ripple’s own cryptocurrency. One can then transfer funds using block chain technology, but the transfers do not have to take place using Ripple’s cryptocurrency or Bitcoin. In other words, I can transfer dollars or euros just like I transfer cryptocurrencies in other systems. I can do this by setting up an account and transferring the funds to another person with an account through an update the public ledger that is distributed across the nodes of the system. This streamlines the payment process without the need to adopt a particular cryptocurrency. One can even use dollars to pay someone in euros. The way the transaction is carried out is by finding traders on the system who are willing to trade dollars for euros and then transferring the euros to the desired party. This service seems to be immediately more valuable than any other service in this space.

So where do I see this going?

Suppose that you are Citibank or JP Morgan Chase. You could actually combine the types of services that are offered by NuBits and Ripple. You have the deposit infrastructure and are already offering online payment systems for bill paying and peer-to-peer exchanges. The major banks have two possible incentives. First, they could offer JP Morgan Bits (or whatever you want to call them) and have them redeemable 1-for-1 with the dollar. They could then partner with retailers (both online and brick and mortar) to offer a service in which JP Morgan deposit holders could carry around something akin to a debit card or even an app on their phone that allowed them to transact by transferring the JP Morgan Bits from the individual to the firm, charging a very small fee for the transfer. They could partner with firms for online bill paying as well. Alternatively, they could skip the issuance of their own “bank bits” and simply use their block chain to transfer dollar balances and other existing currencies. Whether or not the banks decide to have their own cryptocurrency for settling payments would be determined by whether there are advantages to developing brand loyalty and/or if retailers saw this as a way to generate greater competition for developing cheaper payments while maintaining the stability of purchasing power with the “bank bits.”

The basic point here is that banks could see a profit opportunity by eliminating the middleman and transferring funds between customers using the block chain. The payments would be faster and cheaper. In addition, it would provide retailers with much better protection from fraud.

My paper with Thomas Hogan and Will Luther, “The Political Economy of Bitcoin” is now forthcoming from Economic Inquiry. A working paper version can still be found here.

Also, on the same topic, Aaron Yelowitz was kind enough to send me his recent paper that uses Google Trends data to identify the characteristics of Bitcoin users. A link to that paper can be found here.